Finance Essays - Financial Risk
Identify the main types of financial risk that might be faced by a multinational company.
Task 1 : Briefly identify the main types of financial risk that might be faced by a multinational company operating in a global environment. in the light of this, critically evaluate the merits and demerits of forward contracts, futures, options and swaps as methods that might be employed by such a company for hedging these risks.
Task 2: It is often considered that derivatives have a reputation for being risky; critically discuss the issues a company must consider in developing an appropriate hedging strategy.
In this essay I will be discussing the different types of risk a multinational company might face. I will also discuss the advantages and disadvantages hedging against these risks. Also, I will look at which factors are important in developing an effective hedging strategy.
In this section I will first identify and briefly describe the main sources of risk an international multinational company might face. The main type of risk a multinational company might face is that of foreign exchange risk. This is the risk that trading in another country might be more or less profitable depending on the strength of the two countries currencies. For example if a UK company was trading in China then on day 1 the exchange rate might be £1 to 15 Chinese RM. The next day the exchange rate might be £1 to 10 Chinese RM. This would mean that it is now less profitable to be trading in China. This could be due to no fault in the product being traded. Another type of risk that a multinational company or any company might face is that of interest rate risk. This is the risk associated with the movement of the interest rate. This can be linked to foreign exchange risk as the interest rate of a particular country is one factor that goes to determine the exchange rate. The more countries the multinational company trades in the more interest rate risk they will exposed to. Another type of risk is that of political risk. This is when the policies of a country directly affect the multinational company. Trading in more countries means being exposed to greater political risk. Another main type of risk is that of regulatory risk. This is particularly important to a multinational company as it will be trading in many countries. This will mean that it subject to many different regulations. These different regulations will mean that the company will have to spend time and money managing them to ensure they are not breaking any rules. Translating these regulations back to the parent company’s regulations will also be risky as profits could be affected by the translation.
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As well as the above risks I have outlined, there are many other types of risk. This will mean that multinational companies will try to ensure that the risk can be managed. One way of doing this is by using hedging. This is when the company enters into a particular type of financial transaction to try to reduce the company’s risk exposure. These transactions try to lock in a price that the company can try to guarantee. The main financial transactions associated with hedging are forward contracts, futures, options and swaps. I will now look at the advantages and disadvantages of these methods and then I will look at the advantages and disadvantages of hedging in general.
The main advantage of these financial contracts is that it allows the hedger to enter into a financial transaction that will allow him to ‘lock’ in a price. This will mean that the company can draw up a strategy that is devised around this guaranteed price. This ‘locking’ of the price is an advantage as big losses that are associated with the activity are now not possible as if these losses do occur then the future contract or swap will cover these losses. However, a disadvantage of this is that if the activity performs well then the big gains of the activity are not realised as the price has been locked. However, this is not true of all the financial transactions used for hedging. One such is that of options. With an option the hedger can say that he will sell or buy at a certain price. If the real price of the activity goes above this agreed option price then the hedger is not obliged to sell or buy. The high profits from the activity can be realised. However, some authors have observed that buying the option in the first place will even the possible gains out, meaning that no profit is made.
There is a big disadvantage of using future contracts. Although they are relatively simple an easy to use and on paper they can ‘lock’ in a future exchange price, in reality they are much more complex. This complexity gives arise to what is known as basis risk. This arises due to the fact that the exact length of the contract is not known and due to the fact that the hedging asset is not exactly the same as the asset being hedged against.
I will now talk about the general advantages and disadvantages of using these financial transactions. As these are used as hedging methods I will be talking about the advantages and disadvantages of hedging. I will first outline some of the advantages of hedging. The main reason why companies try to use hedging is that they are trying to provide an insurance against a particular investment. This is the same principle as when a company insures against fire and theft. A Company will take out a hedging position to insure that if a certain market condition occurs they do not lose out. Hedging against currency risk is especially important in today’s growing global market. As more and more businesses are trading in many countries then different currencies are being used. An article in Business Week (2005) supports the view that there is increased investment overseas as it states, ‘The smart money is going overseas, because that's where many portfolio managers think they'll get the biggest bang for their buck.’
Another reason for hedging is that many businesses are in the manufacturing, retail or service industries. These companies will have little expertise in predicting future exchange rate changes or changes in prices of commodities. These companies will hedge so risk is reduced. This will mean that they can get on and concentrate on the main activity of their business. However, the hedging process is complex. The use of such methods as options and future contracts requires specialised expertise. This will cost the company money. Also, these personnel will need to be monitored. This is because they could be taking hedging positions that could bankrupt the company. One example of this was that of Nick Leeson at Barings Bank. Over a couple of years he managed to lose close to $1 billion. He was able to hide these losses due to a lack of monitoring.
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There are some authors who believe that hedging can increase the value of a company. One such author was Smith and Stulz (1985). They ‘showed that hedging could increase the value of the firm by reducing the probability, and thus expected costs, of financial distress,’ Hagelin (2003).
I will now outline some disadvantages of hedging. Hedging could cause losses. This is because market conditions could be favourable and the activity of the business is profitable. Therefore, the hedging put in place to reduce risk will now cause losses for the company. The treasurer will now have to explain why these losses have occurred. An article that supports the view of hedging causing loss is that by Cornwell (2005). In this article the author looks at the earnings of Countrywide. The author found that the company lost out due to hedging. The ‘value of the financial hedges fell’ in the business causing a pre tax loss of ‘$278 million’
Also, there are many different methods that can be used to hedge. These methods could be very complex. Which method to use could prove a difficult decision to the company. This decision could affect the amount of profit or loss a company makes from a hedge. An example of this is that of currency risk. With currency risk there are two types of exposure, that of translation and translation. Deciding which to hedge against is a difficult decision. A paper supporting the view of hedging complexity is that of Seiberg (1998). He states that, ‘banks using increasingly complex instruments to hedge their investments’.
In this section I will look at some of the factors that a company needs to look at in order to decide upon a hedging strategy. There are many factors that a company will have to consider, but I will outline some of the main factors. Firstly, a company will need to decide if they have the expertise within the company to perform the hedging activities. Hedging is a complex financial activity and as many companies are in the manufacturing or service industry then they will not have the require expertise. In this case they will have to find the expertise either by hiring the relevant personnel or by contracting the hedge activity out to another company. Either method will be costly and time consuming.
Once the expertise has been obtained then the company still faces many different factors that need careful consideration. One such factor is the level of hedging the company is going to undertake. This will probably depend on the size of the company. If the company is quite large and is exposed to many different types of risk then many different hedges will need to be put in place. On the other hand the company might decide that the hedging is not required. Many authors have argued against the use of hedging, as they believe it has damaging effects. Their argument is that due to positive and negative fluctuation, price rises and falls will even themselves out over a period of time. This will mean that hedging is unnecessary. One such author to observe this was de Saint-Seine (2003). The author is reporting on why the French automotive business does not hedge against currency risk. In the article the author states that the Renault Chairman said, "If you don't hedge, sometimes you win, sometimes you lose, and over the long term, it evens out." Other authors argue that the use of hedging is unnecessary due to the fact that the shareholders of the company will have a diversified portfolio and are therefore hedging by themselves. Seiberg (1998) supports the view of shareholder diversity. They have a quote by Robert A. Eisenbeis, the Atlanta Fed's research director. He said ‘As long as shareholders can diversify their investments, there is no reason for them to care about hedging.’
Another factor that hedgers will have to consider is that of which type of risk will need to be hedged against. Deciding this will be very important and very complex. There are many different types of risk and many different methods that can be used. This decision could effect the amount of profit or loss a company makes from a hedge. For example, when dealing with currency risk there is the consideration of whether to hedge against translation exposure or transaction exposure. Translation exposure is when a foreign companies statements are translated back to the parent companies currency. Transaction exposure is the risk associated with future cash flows being effected by future changes in exchange rates. Much financial literature says that the main one here to hedge against is transaction exposure. Much of the literature states that translation exposure does not need to be hedged against as it does not effect the value of the firm too much. One such journal was by Hagelin (2003). Having both these exposures supports the view that hedging is a very complex procedure.
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In this essay I have described some of the main types of risk. These were foreign exchange risk, interest rate risk an political risk. There are also many other different types of risk a multinational company could face; too many to mention in such a short essay. I also looked at advantages and disadvantages of the different types of hedging methods and hedging itself. I found that there are many good advantages such as insuring a price and reducing risk. I also found many disadvantages such as the complexity of the methods and the potential for massive losses.
I then went on to look at factors a hedging strategy would need to look at. These included hiring the right expertise for the job, choosing the best method, choosing the level of hedging and identifying the types of risk that would be hedged.
Fundamentals of Futures and Options Markets. 4th Edition. J. C. Hull
Multinational Business Finance. 9th Edition. D. K. Eiteman, A. I. Stonehill, M. H. Moffett
Cornwell T. (2005) Hedge Weakness Slow Countrywide’s Growth. Mortgage Servicing News, Vol. 9 Issue 2
de Saint-Seine S. (2003) French won’t hedge currency even though strong euro hurts them. Automotive News Europe, Vol. 8 Issue 13, p1
Hagelin N. (2003) Why firms hedge with currency derivatives: an examination of transaction and translation exposure. Applied Financial Economics, Vol. 13 Issue 1
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